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Learning General Framework for Cost
Objective 1 Allocation

Cost allocation methods comprise an important

part of a companys cost management system.

Four types of cost objectives:

Service departments
Producing departments
Products/services, and
General Framework for Cost Allocation

Producing departments are where employees

Work on the organizations products or services.

Service departments exist only to

support other departments or customers.
General Framework for Cost Allocation

Direct costs can be physically traced to each department.

Indirect costs must be allocated.

Many companies develop allocation methods to

assign service department costs to the producing
General Framework for Cost Allocation

All organizations accumulate costs for their

products or services for financial reporting purposes.

Increasingly, companies measure and manage

the costs and profitability of their customers.

Customer related costs include:

Order processing
Customer service sales commissions
Dedicated customer support
General Framework for Cost Allocation

An accounting system will assign to a departments output

all its direct costs plus all the indirect costs allocated to it.

A cost driver that has a logical, cause-effect relationship

to the cost will be used as a cost-allocation base
Learning Allocation of Service Department
Objective 2 Costs

Establish the details regarding
cost allocation in advance.

Allocate variable- and fixed-
cost pools separately.

Evaluate performance using budgets for
each production and service department.
Service Department Example

5-year lease

Computer Department

School of Business School of Engineering

Service Department Example

Suppose there are two major

purposes for the allocation:

Predicting economic effects

of the use of the computer

Motivating departments and

individuals to use its
capabilities more fully
Service Department Example

The primary activity performed

is computer processing.

Resources consumed include

1. Processing time The budget formula for the
2. Operator time forthcoming year is 100,000
3. Consulting time monthly fixed cost plus 200
4. Energy variable cost per hour of
5. Materials computer time used.
6. Building space
Variable-Cost Pool

The cost driver for the variable-cost pool is

Actual hours of computer time used.

Therefore, variable costs should

be allocated as follows:
Budgeted unit rate X Actual
hours of computer time used
Variable-Cost Pool

Consider the allocation of variable

costs to a department that uses
600 hours of computer time.

600 hours 200 = 120,000

Suppose inefficiencies in the

computer department caused the
variable costs to be 140,000
instead of 120,000.
Variable-Cost Pool

A good cost-allocation scheme would allocate

only the 120,000 to the consuming department
and would let the 20,000 remain as an
unallocated unfavorable budget variance
of the computer department.

This scheme holds computer department managers responsible

for the 20,000 and reduces the resentment of user managers.
Fixed-Cost Pool

The cost driver for the fixed-cost pool is

the amount of capacity required when
the computer facilities were acquired.

Fixed costs should be allocated as follows:

Budgeted percent of capacity available for use

Total budgeted fixed costs
Fixed-Cost Pool

Suppose the deans had originally predicted the

long-run average monthly usage as follows:

School of Business: 210 hours

School of Engineering: 490 hours

How is the fixed-cost pool allocated?

Business: Engineering:
210 700 = 30% 490 700 = 70%
100,000 X .3 = 30,000 100,000 X .7 = 70,000
Fixed-Cost Pool

This predetermined lump-sum approach

is based on the long-run capacity
available to the user, regardless of
actual usage from month to month.

major strength of using capacity available rather

an capacity used when allocating budgeted fixed
sts is that actual usage by user departments does not
ect the short-run allocations to other user departmen
Reciprocal Services

Service departments often support

other service departments in addition
to production departments.

There are two popular methods for

allocating service department costs:

The direct method

The step-down method

Objective 3 Direct and Step-Down Methods

The direct method ignores other service

departments when any given service
departments costs are allocated
to the revenue-producing
(operating) departments.

The step-down method recognizes that some

service departments support the activities
in other service departments as well as
those in production departments.
Direct and Step-Down Methods

Facilities management cost = 1,260,000

Human resources cost = 240,000

Total square footage in production departments:

15,000 processing + 3,000 assembly = 18,000

Total employees in production departments

16 processing + 64 assembly = 80

Square footage in human resources = 9,000

Direct Method

Facilities management cost

allocated to processing =
(15,000 18,000) 1,260,000 = 1,050,000

Facilities management cost

allocated to assembly =
(3,000 18,000) 1,260,000 = 210,000
Direct Method

Human resources cost

allocated to processing =
(16 80) 240,000 = 48,000

Human resources cost

allocated to assembly =
(64 80) 240,000 = 192,000
Step-Down Method

Facilities management allocation:

To human resources:
(9 27) 1,260,000 = 420,000

To processing:
(15 27) 1,260,000 = 700,000

To assembly:
(3 27) 1,260,000 = 140,000
Step-Down Method

Human resources allocation:

240,000 + 420,000 = 660,000

To processing:
(16 80) 660,000 = 132,000

To assembly:
(64 80) 660,000 = 528,000
Step-Down Method

Processing department

Direct Step-Down
Direct department costs 1,000,000 1,000,000
From facilities management 1,050,00 700,000
From Personnel 48,000 132,000
Total costs 2,098,000 1,832,000
Step-Down Method

Assembly department

Direct Step-Down
Direct department costs 1,600,000 1,600,000
From facilities management 210,000 140,000
From personnel 192,000 528,000
Total costs 2,002,000 2,268,000
Costs Not Related to Cost Drivers


1 Identify additional cost drivers.

Allocate all costs by the direct

2 or step-down method using
square footage as the cost-
allocation base.
Objective 4 Traditional Approach

1. Divide the costs in each

producing departments.

Direct costs Indirect costs

2. Assign direct costs to the appropriate

products, services, or customers.
Traditional Approach

3. Select one or more cost pools and related

cost drivers in each production department.

Indirect departmental costs

Cost Cost Cost

pool pool pool
Traditional Approach

4. Allocate costs


Product Product Product

Activity-Based Costing

Step 1:

Determine the key

components of the system.

Step 2:

Develop the relationships among

resources, activities, and cost objectives.
Activity-Based Costing

Step 3:

Collect relevant data concerning costs

and the physical flow of the cost-driver
units among resources and activities.

Step 4:

Calculate and interpret the new

activity-based cost information.
Objective 5 Allocation of Customer Costs

Allocate costs associated with

customer actions to customers.

Customer profitability depends on more than gross

margin, it depends on the costs incurred to fulfill
customer orders and to provide other customer services.
Allocation of Customer Costs

Customer Type 1 Customer Type 2 High

Low Cost to Serve Cost to Serve

Small order quantity

Large order quantity
Many order changes
Few order changes
Large amounts of pre-
Little pre- and
and post-sales support
post-sales support
Expedited scheduling
Regular scheduling
Special delivery requirements
Standard delivery
Frequent returns
Few returns
Allocation of Customer Costs

Customer Type 1 Customer Type 2 High

Cost to Serve
Low Cost to Serve

Buys a mix of Buys a mix of

products that products that
have high gross have lower gross
margins margins
Has a low cost-to- Has a high cost-
serve % to-serve %
Has a high level of Has a low level of
profitability profitability
Allocation of Customer Costs

Assume Cedar City Distributors (CCD), distributes

many products to retail outlets.

The products are classified into just two product groups

apparel and sports gear.

CCD has two types of customers:

1. Small store
2. Large store
Allocation of Customer Costs

CCD uses a simple cost accounting system to calculate

both product and customer profitability.

The only direct costs Indirect costs are

are costs of the allocated to the
purchase of apparel product groups
and sports gear using a single
products. indirect cost pool
for all indirect costs
with pounds of
product as the
allocation base.
Allocation of Customer Costs

etermine customer profitability:

alculate the profit margin per case for each product
Use the product mix ordered by each customer to calculate profitab

Small Stores Large Stores

Cases Profit Margin Total Cases Profit Margin Total
per case Profit Margin per case Profit Margin
parel 600 265.00 159,000 800 265.00 212,000
orts Gear 200 315.00 63,000 800 315.00 252,000
222,000 464,000
ofit Margin Percentage 43.7% 41.4%
Allocation of Costs-to-Serve

Might number of customer orders be a more

plausible cost-allocation base?

The cost of resources used for order processing and

customer service activities should be included in a separate
cost pool and allocated on the basis of number of orders.

This system gives managers at CCD more insight

into operations, and a tool to measure and
manage customer profitability.
Objective 6 Allocation of Central Costs

Many managers believe it is desirable

to fully allocate all costs to the revenue-
producing parts of the organization.

Whenever possible, the preferred

driver for central services is usage.

If a company does allocate the costs of

central services based on sales, although
costs do not vary in proportion to sales, it
should use budgeted, not actual, sales.
Allocation of Central Costs

Usage Not always economically viable


Total assets

Cost of goods sold

Total cost of each division

Objective 7 Allocation of Joint Costs

Two conventional ways of allocating

joint costs to products are widely used:

Physical Relative
units sales values

Joint costs include all inputs of material, labor, and

overhead costs that are incurred before the split-off point.
Allocation of Joint Costs

The physical-units The joint costs are

method requires a allocated based on
common physical each products
unit for measuring percentage of the
the output of each total physical
product. units produced.

Allocation of joint costs should

not affect decisions about the
individual products.
Physical-Units Method

Dow Chemical produces two chemicals, X

and Y. The joint cost is 100,000. X sells
for .09 per liter and Y for .06.

Allocation Sales Value at

Liters Weighting of Joint Costs Split-off Point
X 1,000,000 (10/15)X100,000 66,667 90,000
Y 500,000 (5/15)X100,000 33,333 30,000
1,500,000 100,000 120,000
Relative-Sales-Value Method

The joint costs are allocated based on each

products sales value as a percentage
of the total sales value at split-off.
Relative-Sales-Value Method

When weighting is based on the sales

value of the individual products, the
allocation of a cost to one product
depends upon the sales value of both
Relative Sales
Value at Allocation
Spit-off Point Weighting of Joint Costs
X 90,000 (90/120)X100,000 75,000
Y 30,000 (30/120X100,000 25,000
120,000 100,000
By-Product Costs

A by-product is not individually

identifiable until manufacturing
reaches a split-off point.

They have relatively insignificant

sales value.
By-Product Costs

If an item is accounted for as a

by-product, only separable
costs are allocated to it.

All joint costs are allocated

to the main products.

Any revenues from by-products, less

their separable costs, are deducted
from the cost of the main products.